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Inflation’s greatest trick?

Years of ultra-loose monetary policy appear to have convinced the market that inflation has – temporarily, at least – ceased to be a concern. Yet, even in the disinflationary environment of the last few years, inflation has eroded capital and stunted returns. By blending inflation protection and capital growth in one strategy, Tommaso Mancuso, Head of Hermes Multi Asset, aims to provide smoother absolute returns in real terms for investors.

Inflation is a relentless phenomenon that has manifested in a variety of scenarios over time. When combined with the power of compounding, it can severely damage investors’ capital. For instance, despite the disinflation of recent years, the value of £100 in 2010 is worth only £84 today.

Figure 1. Shrinking: the pound in your pocket

Source: Hermes, Bloomberg as at 31 December 2015

The duration and severity of inflation cycles is difficult to forecast, meaning that in the current environment there is a real chance that investors are overlooking the risk of a sudden spike in inflation – such as the previous peak of 5.6% in 2010-2011.

Real returns are at riskStrategies seeking strong absolute returns should aim to generate substantial capital growth above inflation. Failing to achieve this target would mean that investors lose capital in real terms. Given the risk of inflation surprises, maintaining a robust defence against inflation throughout the cycle is essential.

The case for inflation hedging may be straightforward, but the means of doing so are not. No single asset, including some of the most popular hedges, consistently protects against or outperforms inflation in the long term:

• Inflation-linked bonds are contractually linked to inflation but their prices are heavily exposed to interest rate and duration risk. In addition, the market has priced in negative yields from the instruments, guaranteeing losses for investors who hold them to maturity.• Gold tends to be an ineffective hedge because it reacts to the fear of inflation rather than moving with realised inflation.• Property is an effective inflation hedge when the economy is growing. However, when economic growth is slower or recessionary, this characteristic weakens.• Equities are expected to outperform inflation, but only tend to do so in the very long term. Assuming a three-year holding period and using data from the last 30 years, equities would have outperformed inflation two-thirds of the time but would have incurred significant losses at other points.

With no single asset able to provide long-term inflation protection, we believe in dynamically managing a portfolio of assets that can either match or outperform inflation. This selection of assets should be adjusted as inflationary conditions, or an asset’s relationship with inflation, change.

Generating and defending growthIn the Hermes Multi Asset Inflation Fund (MAIF), we divide our assets into two pools, matching and enhancing, with the aim of protecting and growing capital respectively. To generate attractive absolute returns, we believe that it is not enough to aim to beat an inflation benchmark. Rather, our assessment of the changing relationships between assets and inflation drives our entire investment process, from research through to dynamic asset allocation.

Our focus on inflation should enable us to capture its efficiency as a source of returns. If investable, the UK Retail Price Index (RPI) would be a compelling asset, offering smoother risk-adjusted returns compared to global equity, credit, rate or commodity markets. MAIF should have a similar return profile to RPI as it targets a low tracking error to inflation. As of 30 June 2016, the fund performance was 3.4% year-to-date and 0.78% annualised since inception[1]. The value of investments and income from them may go down as well as up, and you may not get back the original amount invested. Past performance is not a reliable indicator of future results and targets are not guaranteed.

MAIF has a different ‘sweet spot’ in the economic cycle compared to other growth funds due to its focus on inflation protection and sustainable growth. The Fund performs best in an inflationary environment regardless of underlying economic growth, differentiating it from traditional absolute and total-return strategies, whose performance is more dependent on growth.

Figure 2. Inflation protection should differentiate MAIF from peers

Source: Hermes Multi AssetFor illustrative purposes only. The schematic represents the views of the fund manager and are not a reliable indicator of future results. Targets are not guaranteed.

Our targetBy dynamically allocating to a diverse range of assets that can either match or outperform inflation, MAIF aims to deliver a total return of RPI plus 3% over rolling three-year periods while maintaining a low tracking error to inflation.

The views and opinions contained herein are those of Tommaso Mancuso and may not necessarily represent views expressed or reflected in other Hermes communications, strategies or products. The above information does not constitute a solicitation or offer to any person to buy or sell any related securities or financial instruments.